Definition and Example of Rule 10b5-1
Rule 10b5-1 helps create passive investment schemes that companies and corporate insiders use to avoid violations of insider trading rules when buying or selling shares in the company. It was introduced in 2000 and clarifies Section 10(b) of the Exchange Act of 1934 and Rule 10b-5, which addresses securities fraud through insider trading. Company executives are privy to a lot of inside business information that may be construed as MNPI. Rule 10b5-1 allows company insiders to create automated securities trades. This eliminates the need for the company to evaluate whether MNPI played a role each time an insider decides to purchase or sell shares. The materiality only needs to be determined at the time the plan is enacted. When a company’s executives adopt an automated plan under Rule 10b5-1, it protects the company as well as the insider. An automated plan under 10b5-1 can be utilized for the following purposes:
Sale of company shares Purchase of company shares Exercising stock options Stock vesting events where share sale can fund tax withholding required Cashing in for personal milestones that require significant outlay.
For example, an executive at Company A could enter into a plan that calls for the plan administrator to sell 5,000 shares of the executive’s stock holdings in Company A on the first day of four successive months as long as the share price was at least $75. To avoid an accusation of insider trading, an agreement like this must be entered into when the securities holder is not aware of any MNPI. Alternatively, a 10b5-1 plan could instruct the administrator to sell as many shares as necessary to reach a predetermined amount. Or the dates of trade executions could be controlled by the plan’s administrator as long as that party is not aware of MNPI at the time of executing the transaction, and the employee does not exercise influence over the timing of the transaction.
How Rule 10b5-1 Works
A transaction that is part of a plan created under Rule 10b5-1 is deemed lawful and not an attempt to evade the prohibitions of Rule 10b5-1 if it adheres to these stipulations:
The person can demonstrate they entered into a binding agreement to trade securities prior to becoming aware of the MNPI.The transaction amount, price, and date must be specified, or the contract must include a written formula, algorithm, or computer program to determine the amount, price, and date of securities to be purchased or sold. The plan does not permit the securities holder to exercise any subsequent influence over how, when, or whether to execute purchases or sales, provided that any other person exercising such influence must not be aware of MNPI when doing so.The holder must demonstrate that the purchase or sale that occurred was pursuant to the prior contract, instruction, or plan.
Modifications and early termination of a plan are permitted as long as the participant does not possess MNPI, but such a change may weaken a defense against insider trading accusations. Automatic termination or suspension that is tied to company events can be written into a plan.
What Rule 10b5-1 Means for Individual Investors
The rule does not directly impact individual investors but is aimed at protecting retail investor interest. As the SEC states, “the fundamental unfairness of insider trading harms not only individual investors but also the very foundations of our markets, by undermining investor confidence in the integrity of the markets.” However, there have been instances in which company executives have taken advantage of automated plans under Rule 10b5-1 to skirt the rules. In 2010, Countrywide Financial CEO Angelo Mozilo paid a $22.5 million penalty to settle SEC charges that he misled investors in the company as the subprime crisis unfolded. The SEC also alleged that Mozilo engaged in insider trading by setting up four 10b5-1 trading plans while “he was aware of material, non-public information concerning Countrywide’s increasing credit risk and the risk regarding the poor expected performance of Countrywide-originated loans.” Countrywide Financial was a key player in the mortgage industry whose actions contributed to the subprime crisis leading to the Great Recession. Countrywide was acquired by Bank of America in 2008. The focus by SEC authorities on insider trading infractions—and the stiff penalties that accompany them—make well-run 10b5-1 plans effective and important components of corporate compensation programs.
